Businesses May Be Next Target Of Higher Taxes

The personal-taxes-to-personal-income ratio
was 11.7 percent in August, almost back to the 12.3 percent long-term
average. That eases the pressure on the invisible hand to push for
higher tax rates or more aggressive collections.

The federal budget deficit
remains huge. But it is declining: The Congressional Budget Office says
the shortfall narrowed to $642 billion in the fiscal year that ended
Sept. 30, from $1.1 trillion in the 2012 fiscal year. Furthermore,
persistent political gridlock in Washington makes big tax law changes
unlikely.

Chronic slow growth and limited upside potential for stock and
housing prices probably mean that personal taxes won’t grow faster than
personal income in coming quarters, restraining growth in the
taxes-to-income ratio. However, other forces could influence taxes.
Congress and the Obama administration were unable to avoid a partial
government shutdown this month and a fight over lifting the $16.7
trillion debt ceiling.

Beyond those twin crises, Washington needs to deal with the long-postponed costs of Social Security
and Medicare benefits for the increasingly large number of
postwar-generation workers who are retiring. This is the reason that the
narrowing of the federal deficit projected by the CBO will end in the
2016 fiscal year. In later years, substantial increases in Social
Security and Medicare
payroll taxes could cause the ratio of taxes to income, including
social insurance taxes, to rise above its long-run flat average of 19.7
percent.

Top Rate

The changes in personal taxes of
recent decades have been accompanied by some major changes in corporate
taxation. U.S. businesses are clamoring for tax reform, especially
changes aimed at lowering the 35 percent top rate, which is about the
highest in the world, though it’s down from 52 percent in 1964.

The real rate is 40 percent when state and local government corporate income taxes are included. In late July, President Barack Obama
offered to work with Congress to overhaul corporate taxes on the
condition that any one-time revenue gains are used to fund spending on
programs he favors. In mentioning one-time gains, he indicated that he
is, in effect, thinking about eliminating many tax code provisions that
reduce the effective corporate profit tax rate well below 35 percent.

The Government Accountability Office
estimates that the effective rate on worldwide income for large,
profitable U.S. companies averaged 12.6 percent in 2010. When taxes paid
to foreign as well as U.S. state and local governments are included,
the effective rate rose to 16.9 percent, still only about half the 35
percent top federal marginal rate. Federal corporate tax collections
dropped to $181 billion for 2011 from a peak of $370 billion for 2007,
at the height of the housing-led boom. They are expected to rise to $288
billion for the 2013 fiscal year, which ended Sept. 30.

An
especially contentious issue is foreign earnings of U.S. companies that
aren’t subject to taxes until they are repatriated. By contrast, most
other developed countries tax only domestic profits. Many U.S.
corporations have no incentive to return foreign earnings and pay the
U.S. taxes. But there is intense political pressure for them to do so.

In May, Apple Inc. Chief Executive Officer Tim Cook testified before the Senate Permanent Subcommittee on Investigations. The panel headed by Senator Carl Levin,
a Michigan Democrat, found that Apple avoided paying $9 billion in U.S.
taxes in 2012, and $74 billion over the past four years, largely by
basing profitable operations in Ireland, which has consistently used low
tax rates to attract foreign business.

'Holy Grail'

Levin called this "the Holy Grail of tax avoidance.” Cook said Apple
favored corporate tax reform, including a lower tax rate, but with a
reasonable levy on foreign earnings. The adverse publicity led the Irish
government to announce plans to change the tax rules affecting Apple
and other companies beginning in 2015.

Audit Analytics
estimated that total U.S. corporate profit parked abroad rose 15
percent last year, to $1.9 trillion. This partially reflects the 70
percent increase in offshore earnings in the last five years. Offshore
profits are normally taxed where they are earned, so companies often use
a technique known as transfer pricing to shift earnings to low-tax
countries. The tactic sometimes involves moving valuable intellectual
property so the high profits from royalty payments will be realized in
lower-tax jurisdictions.

A reform of U.S. corporate taxes could reduce the top marginal rate, but at the expense of higher taxes
elsewhere. Congressional proposals include a special low tax rate on
profit held offshore, which would encourage companies to bring the money
home. Eventually, it could mean an end to taxes on overseas earnings,
bringing the U.S. in line with other countries. Other ideas being
proposed to raise revenue include stretching out depreciation timetables
and changes in inventory accounting.

From the standpoint of
economic efficiency, trading corporate tax loopholes for lower tax rates
makes sense. As companies adapt to special tax provisions, normal
market-driven responses are distorted. In any event, major tax reform
and simplification for corporate or personal taxes is very unlikely as
long as gridlock and partisan animosity persist in Washington.

In addition, the persistence of large federal deficits
means the long-run decline in corporate tax rates is unlikely to
continue unless lower rates are traded for higher business taxes
elsewhere.

Even
as corporate taxes as a percentage of profits are going down, taxes as a
share of gross value-added of corporate business -- essentially
corporate sales -- have been flat since the early 1980s because profit
margins have been rising. In recent years, U.S. businesses have slashed
labor and other costs in response to the lack of pricing power and
declining inflation as well as the meager sales volume growth in the
sluggish global recovery.

But productivity growth from
cost-cutting and other means is no longer easy to come by. Also, the
growth in value from productivity-enhancing technology equipment and
software in the decade ending 2011 has been the weakest since World War
II. Furthermore, neither capital nor labor has the upper hand
indefinitely in a democracy, and compensation’s share of national income
has been compressed as profit’s share leaped.

Corporate earnings
are also vulnerable to the strengthening dollar, which reduces the
value of revenue from exports and foreign earnings by U.S.
multinationals. And exports and foreign earnings of U.S. companies are
under pressure, especially in developing countries where growth has
slowed.

China’s growth is slowing as it shifts to an economy led
by consumer demand and away from exports, which are depressed by weak
demand from the U.S. and Europe. China has also vastly overbuilt its
infrastructure. Vacant cities and other excess capacity could become
considerable problems, particularly for the lenders who financed them.
Deceleration in China implies slow growth for the other developing
countries that have thrived by exporting commodities and components to
the Chinese manufacturing juggernaut.

Meanwhile, the prospective
tapering of Federal Reserve asset purchases and the related interest
rate increases that have already occurred are causing financial harm to
those nations.

Earlier, the likes of Brazil, India, Indonesia and
Turkey were almost overwhelmed by inflows of hot money that drove up
the value of their currencies and financed their large current-account
deficits. Now that hot money is rushing out, leaving them with three
unsavory choices. They can allow their currencies to slide, which aids
exports but also promotes inflation as import prices jump. They can
raise interest rates to help retain foreign money, but that threatens
growth. Or they can impose capital controls to keep money from leaving,
but that discourages future inflows and triggers huge outflows when
controls are lifted.

The invisible hand will probably continue to
favor taxpayers when the tax-to-income ratio rises considerably above
the 12.3 percent long-run average, and it will increase their tax payments
when the ratio drops substantially below. The long-term downtrend in
corporate tax rates, however, is unlikely to persist unless lower rates
are traded for higher business taxes elsewhere.

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